CHAPTER 17
Short-Term FinancingWorking capital financing policies Accounts payable (trade credit) Commercial paper
Short-term bank loans Secured short-term credit
Working Capital Financing Policies
Maturity Matching: Matches the maturity of the assets with the maturity of the financing. Aggressive: Uses short-term
(temporary) capital to finance some permanent assets.
Conservative: Uses long-term (permanent) capital to finance some temporary assets.
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Years $
Perm C.A.
Fixed Assets Temp. C.A.
What are “permanent” assets? S-T Loans L-T Fin: Stock, Bonds, Spon. C.L. Maturity Matching Financing Policy
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Years $
Perm C.A.
Fixed Assets Temp. C.A.
More aggressive the lower the dashed line. S-T
Loans L-T Fin: Stock, Bonds, Spon. C.L. Aggressive Financing Policy
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Conservative Financing Policy
Fixed Assets
Years $
Perm C.A. L-T Fin:Stock,
Bonds, Spon. C.L. Marketable Securities
Zero S-T debt
17 - 6 The choice of working capital policy is
a classic risk/return tradeoff.
The aggressive policy promises the highest return but carries the greatest risk.
The conservative policy has the least risk but also the lowest expected return.
The moderate (maturity matching) policy falls between the two extremes.
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What is short-term credit? What are the major sources? Short-term credit: Debt requiring
repayment within one year. Major sources:
zAccruals
zAccounts payable (trade credit) zCommercial paper
zBank loans
17 - 8 Short-term debt is riskier than
long-term debt for the borrower.
zShort-term rates may rise.
zMay have trouble rolling debt over.
Advantages of short-term debt.
zTypically lower cost.
zCan get funds relatively quickly with
low transactions costs.
zCan repay without penalty.
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Is there a cost to accruals? Do firms have much control over
amount of accruals?
Accruals are free in the sense that no explicit interest is charged. However, firms have little control
over accrual levels, which are influenced more by industry custom, economic factors, and tax laws than by managerial actions.
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What is trade credit?
Trade credit is credit furnished by a firm’s suppliers.
Trade credit is often the largest source of short-term credit for small firms.
Trade credit is spontaneous and relatively easy to get, but the cost can be high.
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JAWS buys $3,030,303 gross, or $3,000,000 net, on terms of 1/10, net 30. However, the firm pays on Day 40. How much free and costly trade credit are they getting?
What is the cost of the costly trade credit?
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Gross/Net Breakdown Company buys goods worth
$3,000,000. That’s the cash price. They must pay $30,303 more over
the year if they forego the discount. Think of the extra $30,303 as a
financing cost similar to the interest on a loan.
Must compare that cost with the cost of alternative credit.
Payables level if discount is taken: Payables = $8,333 (10) = $83,333.
Credit Breakdown:
Total trade credit = $333,333 Free trade credit = 83,333 Costly trade credit = $250,000 Payables level if don’t take discount:
Payables = $8,333 (40) = $333,333. Net daily purchases = $3,000,000/360
= $8,333. Nominal Cost of Costly Trade Credit
But the $30,303 in lost discounts is paid all during the year, not just at year-end, so the EAR is higher. Firm loses 0.01($3,030,303) = $30,303 of discounts to obtain $250,000 in extra trade credit, so
kNom==== ==== ====
$30,
$250, . .
303
000 0 1212 12 12%.
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Nominal Cost Formula, 1/10, net 40
Pays 1.01% 12 times per year. kNom= x
= x = 0.0101 x 12 = 0.1212 = 12.12%.
Discount %
1 - Discount % Days taken - Discount period360 1
99 36030
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Effective Annual Rate, 1/10, net 40
Periodic rate = 0.01/0.99 = 1.01%. Periods/year = 360/(40 - 10) = 12. EAR = (1 + Periodic rate)n- 1.0
= (1.0101)12- 1.0 = 12.82%.
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Commercial Paper (CP)
CP are short term notes issued by large, strong companies. JAWS could not issue CP; the company is too small.
CP trades in the market at rates just above the T-bill rate.
CP is bought by banks and other companies, then held as marketable securities for liquidity purposes.
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A bank is willing to lend JAWS $100,000 for 1 year at an 8 percent nominal rate. What is the EAR under
the following five loans? 1. Simple annual interest, 1 year. 2. Simple interest, paid monthly. 3. Discount interest.
4. Discount interest with 10 percent compensating balance.
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Why must we use Effective Annual Rates (EARs) to evaluate the loans? In our examples, the nominal
(quoted) rate is 8% in all cases. We want to compare loan cost rates
and choose the alternative with the lowest cost.
Because the loans have different terms, we must make the
comparison on the basis of EARs.
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Simple Annual Interest, 1-Year Loan
“Simple interest” means not a discount or add-on loan.
Interest = 0.08($100,000) = $8,000.
On a simple interest loan of one year, kNom= EAR.
.
kNom====EAR==== ==== ====
$8,
$100, . .
000
000 0 08 8 0%
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Simple Interest, Paid Monthly Monthly interest = (0.08/12)($100,000)
= $666.67.
-100,000.00 -666.67
100,000
0 1 12
-667.67
N I/YR PV PMT FV
12 100000 -666.67 -100000
0.66667
(More…)
...
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kNom= (Monthly rate)(12) = 0.66667%(12) = 8.00%.
or: 8 NOM%, 12 P/YR, EFF% = 8.30%. Note: If interest were paid quarterly, then:
Daily, EAR = 8.33%. EAR====1++++0 08 −−−− ====
4 1 8 24%.
4
.
.
EAR==== ++++
1 −−−− ==== 0 08
12 1 8 30%.
12
.
.
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8% Discount Interest, 1 Year Interest deductible = 0.08($100,000)
= $8,000.
Usable funds = $100,000 - $8,000 = $92,000.
N I/YR PV PMT FV
1 92 0 -100
8.6957% = EAR
0 1
i = ?
92,000 -100,000
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Discount Interest (Continued)
Amount borrowed =
= = $108,696. Amount needed 1 - Nominal rate (decimal)
$100,000 0.92
Need $100,000. Offered loan with terms of 8% discount interest, 10%
compensating balance.
(More...)
=
= = $121,951. Amount needed 1 - Nominal rate - CB
$100,000 1 - 0.08 - 0.1 Face
amount of loan
Interest = 0.08 ($121,951) = $9,756.
. received Amount
paid Interest Cost====
EAR correct only if amount is borrowed for 1 year.
(More...)
EAR==== $9, ====
$100, .
756
000 9 756%.
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This procedure can handle variations.
N I/YR PV PMT FV
1 100000 -109756
9.756% = EAR 0
0 1
i = ?
121,951 Loan -121,951
+ 12,195 -109,756 -9,756 Prepaid interest
-12,195 CB
100,000 Usable funds
8% Discount Interest with 10% Compensating Balance (Continued)
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1-Year Installment Loan, 8% “Add-On”
Interest = 0.08($100,000) = $8,000.
Face amount = $100,000 + $8,000 = $108,000. Monthly payment = $108,000/12 = $9,000.
= $100,000/2 = $50,000. Approximate cost = $8,000/$50,000 = 16.0%. Average loan
outstanding
(More...)
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Installment Loan
To find the EAR, recognize that the firm has received $100,000 and must make monthly payments of $9,000. This constitutes an ordinary annuity as shown below:
-9,000 100,000
0 1 12
i = ?
-9,000 -9,000
Months 2
...
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N I/YR PV PMT FV
12 100000 -9000
1.2043% = rate per month 0
kNom= APR = (1.2043%)(12) = 14.45%.
EAR = (1.012043)12- 1 = 15.45%.
14.45 NOM enters nominal rate
12 P/YR enters 12 pmts/yr
EFF% = 15.4489 = 15.45%. 1 P/YR to reset calculator.
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What is a secured loan? In a secured loan, the borrower
pledges assets as collateral for the loan.
For short-term loans, the most commonly pledged assets are receivables and inventories. Securities are great collateral, but
generally firms needing short-term loans generally do not have securities.
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Chapter 17 Extension: Secured Short-Term Financing
Accounts receivable financing Inventory financing
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Important Legal Forms
Security Agreement: Standard form under the Uniform Commercial Code. Specifies when lender can claim collateral if default occurs. UCC Form-1: Filed with Secretary of
State to establish collateral claim. Prospective lenders will do a claims search, and won’t make the loan if a prior UCC-1 has been filed.
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What is the difference between pledging and factoring receivables?
If receivables are pledged, the lender has
recourse against both the original buyer of the goods and the borrower.
When receivables are factored, they are
generally sold, and the buyer (lender) has no recourse to the borrower.
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What are three forms of inventory financing?
Blanket lien.
Trust receipt.
Warehouse receipt.
The form used depends on the type of
